Tutorial on Annual Percentage Rate (APR)

tutorial on annual percentage Rate ( APR )

Last Revised August 8, 2010 

What Is the APR?

APR is a measure of the cost of credit that includes loan fees paid to
the lender upfront, as well as the interest rate. The higher are the
loan fees, the larger will be the APR relative to the rate. If there are
no loan fees and the rate is fixed through the life of the loan, the
APR
will equal the rate.

What Is the Purpose of the APR?

To provide a single comprehensive measure of the cost of credit
to the
borrower, which they can use to compare loans of different types and
features, and loans offered by different loan providers.

The APR is a mandated disclosure under Truth in Lending. Mortgage
shoppers confront it as soon as they search for interest rate quotes,
because the law requires that any rate quote must also show the APR.

Can All Borrowers Rely Safely on the APR?

No, some should ignore the APR, including:
APR is a measure of the monetary value of credit that includes lend fees paid to the lender upfront, vitamin a well as the interest rate. The higher are the lend fees, the larger will be therelative to the rate. If there are no lend fees and the pace is fixed through the life of the loan, thewill equal the rate.To provide a single comprehensive examination measure of theto the borrower, which they can use to compare loans of different types and features, and loans offered by unlike loan providers.Theis a mandate disclosure under. mortgage shoppers confront it arsenic soon as they search for interest pace quotes, because the jurisprudence requires that any rate quotation mark must besides show theNo, some should ignore the APR, including :

* Borrowers who expect that they will sell their house or refinance the mortgage within 7 years.
* Borrowers looking to raise cash, who are comparing the price of a cash-out refinance with the monetary value of a second mortgage.
* Borrowers with short cash who need a high-rate lend with negative
points
( rebates ) to cover their costs.
* Borrowers shopping for a home fairness channel of citation ( HELOC ).

The APR is most useful for borrowers shopping for an adjustable rate
mortgage (ARM), who expect to hold the mortgage a long time, and who are
not doing a cash-out refinance, a low or no-cost mortgage, or a HELOC.

Why Should Borrowers Who Expect To Have Their Mortgage Less Than 7 Years
Ignore The APR?

Because over short periods, the APR is biased in favor of loans with low
interest rates and high fees.

The APR combines fees paid upfront with interest paid every month. It
does this by dividing the fees over the future life of the mortgage. In
any month, the interest payment, plus the upfront fees allocated to that
month, divided by the loan balance at the end of the preceding month,
equals the APR. See

In allocating the fees, it is assumed that the loan runs to term. A
30-year loan runs for 30 years, for example, and a 15-year loan runs for
15 years. This is contrary to fact, most loans are paid off well before
term. While data on mortgage life are sketchy, the average life of
30-year loans today is certainly below 7 years.

The assumption that loans run to term reduces the fees allocated to each
month, reducing the APR relative to what it would be if the loan was
paid off before term. This imparts a bias in favor of loans with low
interest rates and high fees.

For example, in shopping for a $200,000 30-year fixed-rate loan, Jones
is offered 7% with $5500 in fees and APR of 7.28%, versus 6.5% with
$11,500 in fees and APR of 7.08%. A comparison of APRs suggests that the
6.5% loan will cost less.

However, if Jones sells the house or refinances after 7 years, the APRs
calculated over 7 years would be 7.53% for the 7% loan and 7.61% for the
6.5 % loan. The conclusion regarding the least costly loan is reversed.

If fees are about the same, this bias in the APR disappears. On
fixed-rate mortgages (FRMs), however, the borrower can compare rates and
doesn’t need the APR. On ARMs, in contrast, the APR can be useful, as
noted below.

 Could This Bias in the APR Be Eliminated?

Yes, the bias could be eliminated by making the time period used in the
calculation “borrower specific” — calculated for each borrower over the
period specified by the borrower. It takes only a minor tweak in the
computer programs used to calculate APR to make the time period borrower
specific. Where the borrower has not yet been identified, as in
newspaper ads, several APRs could be shown, e.g., 3 years, 7 years and
term.

Why Should the APR on a Cash-Out Refinancing Be Ignored?

Because it fails to take account of the rate on the old mortgage that is
refinanced.

If the rate on the old mortgage is below the rate on the new larger
mortgage, failure to account for the loss of the lower rate can falsely
suggest that the cash-out refinance will cost less than a second
mortgage that raises the same amount of cash.

For example, a borrower has a 7.5% mortgage with balance of $160,000 and
needs to raise $20,000. The rate on a cash-out refinance for $180,000 is
8%, and if there are no fees, the APR is 8%. The rate on a second
mortgage of $20,000 is 9% and if there are no fees, the APR is 9%. A
comparison of APRs suggests that the cash-out refinance is cheaper, but
it isn’t. The APR of 8% does not account for the 1/2% increase on
$160,000 which would be avoided by selecting the second mortgage.

Is There A Way to Eliminate The APR Bias on a Cash-Out Refinance?

To make it comparable to the APR on a second mortgage, the APR on the
cash-out refinance must be converted into a “net-cash APR”. A net-cash
APR compares the difference in payments between the old and new loan to
the amount of cash received by the borrower. It thus takes account of
the difference in rate between the old mortgage and the new one.

But this will not happen anytime soon. Meanwhile, the best way to avoid
going astray is to use calculator 3d (

Why Should the APR on a High-Rate/Negative Point Loan Be Ignored?

Because there is no clear rule regarding the treatment of negative
points in the APR calculation. Different lenders do it in different
ways, which means that their APRs are not comparable.

When borrowers pay positive points and/or other fees, which is the usual
case, every lender calculates the APR in the same way. The APRs in such
cases are always higher than the rates. But on high-rate loans on which
lenders pay rebates that cover some or all of the third party fees,
there is no consensus on how to calculate the APR. It should but may not
be below the interest rate.

On June 9, 2006 I checked this at 4 on-line lenders who quote prices for
high rate loans: Amerisave, Eloan, AMRO and IndyMac. Only Amerisave
included the full rebate in the calculation, as I would, resulting in an
APR significantly below the rate. IndyMac used only a small amount of
the rebate in the calculation, so the APR was only slightly below the
rate. Eloan and AMRO didn’t use any of the rebate, so their APRs were
higher than the rate.

An implication of this is that the APR stated for a “no-cost” mortgage
where the lender pays all the settlement costs can be misleadingly high.
But borrowers shopping for no-cost mortgages don’t need an ARP, they can
shop for the lowest rate.

Other borrowers who need a rebate should shop for the largest rebate at
a specified rate. For example, I shopped the 4 lenders mentioned earlier
at 7.25% on a 30-year FRM of $400,000, and found rebates ranging from
$10,133 to $4300.

Why Is the APR on a HELOC Not Useful?

Because the APR on a HELOC is the initial interest rate, which the
borrower already knows.

A HELOC is a line of credit, as opposed to a loan for a specified sum,
and it is always adjustable rate. The interest rate on all HELOCs is
equal to the prime rate plus a margin, and the rate adjusts the first
day of the month following a change in the prime rate. If the HELOC has
an introductory guaranteed rate, any rate adjustments are deferred, but
typically guaranteed rates hold for only a few months.

The critical price variable is the margin, but that is not a required
disclosure. The APR is a required disclosure, but it is defined as the
interest rate, which can be well below the prime rate plus the margin.
That makes it a useless redundancy. Borrowers shopping for a HELOC
should ask for the margin.

Why Is The APR On An ARM A Useful Measure For Borrowers With Long Time
Horizons?

Because the APR calculation on an ARM takes account of important ARM
features that the borrower often doesn’t know or understand.

The APR calculation on an ARM uses the initial rate for as long as it
lasts, and then uses the current value of the rate index used by the
ARM, plus the margin, subject to any rate adjustment caps. It is assumed
that rate index used by the ARM stays the same for the life of the loan.
This is called a “no-change” or “stable- rate” scenario.

Here is an illustration from June, 2006. A 7/1 ARM that uses as its
index 1-year Libor had an initial rate of 6.25% with zero points. The
value of the index at that time was 5.426% and the margin was 2.25%,
summing to 7.676%. The APR is 6.912%, based on 6.25% for 7 years, and
7.676% for the remaining 23. The rate adjustment cap of 5% did not
figure in the calculation because the rate increase was smaller.

The APR on an ARM thus takes account of the initial rate and period, the
current value of the rate index, the margin, and rate caps. Borrowers
often don’t have this information, or don’t know what to do with it if
they do have it. This makes the APR on an ARM a useful piece of
information, provided that the borrower intends to have the mortgage at
least 7 years, and that the ARM is not a HELOC.

But there is one proviso. The APR on an ARM assumes that the rate index
stays at the initial level through the entire life of the loan. In
general, this is the single best assumption you can make, since no one
can predict interest rates years in advance. However, when interest
rates are as low as they have ever been, as in 2003-2004, there is much
more scope for a future increase than decrease. There is a limit on how
low rates can go, but no limit on how high they can go. Under these
circumstances, I would be hesitant about comparing the APR on an ARM
with that on a FRM.

When Is The APR Locked?

With some lenders, immediately, with others, not until closing.

A lock typically covers the rate and points, but not fixed-dollar fees
charged by the lender. Since fixed-dollar fees are a component of the
APR, a lender
who does not include fixed-dollar fees in its lock can raise them, along
with the APR, anytime before closing. A new Truth in Lending statement
must be issued each time, but that does not help the borrower nor deter
the lender. A lender who delays final approval of the loan until closing
can do the same. The Good Faith Estimate that became
effective January 1, 2010 eliminated the ability of lenders to raise
fixed-dollar fees after a GFE was issued, but delaying loan approval
remained an open possibility.

This potential for abuse could be fixed simply by ruling that a lender
locking the price also locks the APR. See

Borrowers avoid the problem if they deal with a mortgage broker, because
brokers won’t tolerate a scam that puts money only in the lender’s
pocket. See

Can I Calculate the APR Myself?

On a fixed-rate mortgage, it can be done with an inexpensive hand
calculator, such as the HP 10B.

Assume the loan amount is $100,000, term 360 months, rate 6%, and APR
fees $2,000. The last consists of all lender charges, but not charges
for appraisal, credit or other third party services.
The APR is most useful for borrowers shopping for an adjustable rate mortgage ( ARM ), who expect to hold the mortgage a long time, and who are not doing a cash-out refinance, a low or, or a HELOC.Because over short periods, theis biased in party favor of loans with moo interest rates and high fees.The APR combines fees paid upfront with matter to paid every month. It does this by dividing the fees over the future life of the mortgage. In any month, the matter to payment, plus the upfront fees allocated to that month, divided by the lend balance wheel at the end of the preceding calendar month, equals the APR. See annual Percentage Rate Simplified In allocating the fees, it is assumed that the loan runs to condition. A 30-year loanword runs for 30 years, for example, and a 15-year loanword runs for 15 years. This is contrary to fact, most loans are paid off well before term. While data on mortgage life are sketchy, the average life of 30-year loans today is surely below 7 years.The assumption that loans run to term reduces the fees allocated to each calendar month, reducing the APR relative to what it would be if the lend was paid off before term. This imparts a bias in prefer of loans with low matter to rates and high fees.For exemplar, in shop for a $ 200,000 30-year fixed-rate lend, Jones is offered 7 % with $ 5500 in fees and APR of 7.28 %, versus 6.5 % with $ 11,500 in fees and APR of 7.08 %. A comparison of APRs suggests that the 6.5 % lend will cost less.However, if Jones sells the house or refinances after 7 years, the APRs calculated over 7 years would be 7.53 % for the 7 % loan and 7.61 % for the 6.5 % loan. The conclusion regarding the least costly lend is reversed.If fees are about the like, this bias in the APR disappears. On fixed-rate mortgages ( FRMs ), however, the borrower can compare rates and doesn ’ t need the APR. On ARMs, in contrast, the APR can be utilitarian, as note below.Yes, the bias could be eliminated by making the prison term time period used in the calculation “ borrower specific ” — calculated for each borrower over the period specified by the borrower. It takes only a minor fine-tune in the calculator programs used to calculate APR to make the time period borrower specific. Where the borrower has not so far been identified, as in newspaper ads, several APRs could be shown, for example, 3 years, 7 years and term.Because it fails to take report of the rate on the honest-to-god mortgage that is refinanced.If the rate on the honest-to-god mortgage is below the rate on the new larger mortgage, failure to account for the loss of the lower rate can falsely suggest that the cash-out refinance will cost less than a second mortgage that raises the same amount of cash.For case, a borrower has a 7.5 % mortgage with balance of $ 160,000 and needs to raise $ 20,000. The rate on a cash-out refinance for $ 180,000 is 8 %, and if there are no fees, the APR is 8 %. The rate on a second mortgage of $ 20,000 is 9 % and if there are no fees, the APR is 9 %. A comparison of APRs suggests that the cash-out refinance is cheaper, but it isn ’ thymine. The APR of 8 % does not account for the 1/2 % addition on $ 160,000 which would be avoided by selecting the second mortgage.To make it comparable to the APR on a second mortgage, the APR on the cash-out refinance must be converted into a “ net-cash APR ”. A net-cash APR compares the remainder in payments between the old and modern loanword to the measure of cash received by the borrower. It therefore takes history of the dispute in pace between the old mortgage and the new one.But this will not happen anytime soon. interim, the best way to avoid going wide is to use calculator 3d ( Cash-Out Refi Vs Second Mortgage ). The calculator compares all the costs over a future time period of the existing loanword plus a second with the costs of the new cash-out refi. It besides shows the “ break even ” rate on the moment, which is the highest pace you can pay on the moment and come out ahead of the cash-out refi.Because there is no net convention regarding the treatment of minus points in the APR calculation. Different lenders do it in different ways, which means that their APRs are not comparable.When borrowers pay cocksure points and/or early fees, which is the usual case, every lender calculates the APR in the same direction. The APRs in such cases are always higher than the rates. But on high-rate loans on which lenders pay rebates that cover some or all of the third gear party fees, there is no consensus on how to calculate the APR. It should but may not be below the interest rate.On June 9, 2006 I checked this at 4 on-line lenders who quote prices for senior high school rate loans : Amerisave, Eloan, AMRO and IndyMac. merely Amerisave included the wide rebate in the calculation, as I would, resulting in an APR significantly below the rate. IndyMac used only a small sum of the rebate in the calculation, so the APR was entirely slenderly below the rate. Eloan and AMRO didn ’ deoxythymidine monophosphate use any of the rebate, so their APRs were higher than the rate.An implication of this is that the APR stated for a “ no-cost ” mortgage where the lender pays all the village costs can be deceptively high. But borrowers shopping for no-cost mortgages don ’ t need an ARP, they can shop for the lowest rate.Other borrowers who need a rebate should shop for the largest rebate at a specify pace. For example, I shopped the 4 lenders mentioned earlier at 7.25 % on a 30-year FRM of $ 400,000, and found rebates ranging from $ 10,133 to $ 4300.Because the APR on a HELOC is the initial interest rate, which the borrower already knows.A HELOC is a line of credit, as opposed to a loan for a intend sum, and it is constantly adjustable rate. The concern pace on all HELOCs is equal to the prime pace plus a margin, and the rate adjusts the beginning day of the month following a change in the prime rate. If the HELOC has an introductory guarantee rate, any pace adjustments are deferred, but typically guaranteed rates hold for only a few months.The critical price variable is the gross profit, but that is not a necessitate disclosure. The APR is a ask disclosure, but it is defined as the concern rate, which can be well below the prime rate plus the margin. That makes it a useless redundancy. Borrowers shopping for a HELOC should ask for the margin.Because the APR calculation on an ARM takes explanation of crucial ARM features that the borrower much doesn ’ thymine know or understand.The APR calculation on an ARM uses the initial rate for a long as it lasts, and then uses the current rate of the rate index used by the ARM, plus the gross profit, capable to any rate alteration cap. It is assumed that rate index used by the ARM stays the same for the life of the loan. This is called a “ no-change ” or “ stable- rate ” scenario.Here is an illustration from June, 2006. A 7/1 branch that uses as its index 1-year Libor had an initial rate of 6.25 % with zero points. The value of the index at that clock time was 5.426 % and the allowance was 2.25 %, summing to 7.676 %. The APR is 6.912 %, based on 6.25 % for 7 years, and 7.676 % for the remaining 23. The rate alteration capital of 5 % did not figure in the calculation because the rate increase was smaller.The APR on an ARM frankincense takes bill of the initial rate and period, the stream value of the rate index, the margin, and rate caps. Borrowers frequently don ’ thyroxine have this information, or don ’ thyroxine know what to do with it if they do have it. This makes the APR on an ARM a useful piece of information, provided that the borrower intends to have the mortgage at least 7 years, and that the ARM is not a HELOC.But there is one provision. The APR on an ARM assumes that the rate index stays at the initial degree through the integral life of the loanword. In general, this is the single best presumption you can make, since no matchless can predict interest rates years in advance. however, when interest rates are american samoa low as they have ever been, as in 2003-2004, there is much more telescope for a future increase than decrease. There is a terminus ad quem on how low rates can go, but no specify on how high gear they can go. Under these circumstances, I would be hesitant about comparing the APR on an arm with that on a FRM.With some lenders, immediately, with others, not until closing.A lock typically covers the rate and points, but not fixed-dollar fees charged by the lender. Since fixed-dollar fees are a part of the APR, a lender who does not include fixed-dollar fees in its lock can raise them, along with the APR, anytime before close. A new Truth in Lending instruction must be issued each time, but that does not help the borrower nor deter the lender. A lender who delays final examination approval of the lend until close up can do the same. Thethat became effective January 1, 2010 eliminated the ability of lenders to raise fixed-dollar fees after a GFE was issued, but delaying lend blessing remained an open possibility.This electric potential for abuse could be fixed plainly by ruling that a lender locking the monetary value besides locks the APR. See Why Isn ’ t the APR Locked With the Rate Borrowers avoid the problem if they deal with a mortgage broke, because brokers won ’ thyroxine tolerate a victimize that puts money only in the lender ’ s pouch. See How much protection Does a mortgage Broker Provide ? Borrowers can besides avoid the trouble by lone dealing with lenders who guarantee their fees and show them on their vane sites.On a fixed-rate mortgage, it can be done with an cheap hand calculator, such as the HP 10B.Assume the loan sum is $ 100,000, term 360 months, rate 6 %, and APR fees $ 2,000. The last consists of all lender charges, but not charges for appraisal, credit or early third party services.

1. record : -100000 in PV, 360 in N, 6 in I/Yr and 0 in FV.

2. Solve for PMT = 599.5505.

3. beat PMT up to 599.56, enter this number in PMT.

4. Enter loan amount less APR fees in PV as -98000.

5. Solve for I/Yr = 6.190. This is the APR .

reference : https://www.peterswar.net
Category : Finance

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